Why “Buy What You Know” Should be “Buy What You Understand”

Peter Lynch became a famous investment guru by arguing that we should all, “Buy what you know.” This sentiment is now routinely espoused by financial magazines and blogs who struggle to come up with daily content that the average person will understand. The problem is that this doesn’t really work and it’s actually pretty likely to negatively influence investors as they overestimate the importance of their daily preferences in their day-to-day experience. This is why I'm a big advocate for index investing with these simple index ETFs or through a “hands off” investing solution such as Wealthsimple.

I’m a much bigger proponent of Warren Buffett’s approach which is to buy what you understand. The thing is that guys like Lynch and Buffett both know and understand so much more than the average retail investor does, that applying their strategies is nearly impossible for most of us. When Lynch sees a product, he is able to internalize its appeal to him as a consumer, alongside heaps of information he has already has on production costs, management status, international considerations, sector competition, patent laws, and thousands of other variables that would never cross most peoples’ minds when they say, “Hey everyone loves Beanie Babies today, I bet that company is going to make tons of money in a few years.”

Your Instincts Probably Suck

Just because you see a lot of people around you wearing clothing with some preppy brand name proudly displayed (you know, the kind of stuff that says, “I badly need this status symbol to show that I am upper-middle class no matter how douchey it makes me look to others”) doesn't mean that the company is a good investment. In fact, it has almost no relevance to whether it is a good investment at all. Most individuals only interact with other people who much like them in terms of values and socio-economic status. This means that your observations – or what you “know” – is inherently bias and flawed in terms of drawing conclusions from a sample that isn’t even close to representative. There are all kinds of psychological reasons for this – check out the book Sway for more details.

“Golf Is a Good Walk Ruined” – Mark Twain

On the flip side of this argument we have one of my favorite investing bloggers to read – JT McGee from Money Mamba. Sometimes this guy almost succeeds in bringing me over to the dark side of active management – then I realize I’m not as smart nor as committed as he is and hug my low-cost index ETFs close to my chest. JT’s self-described best move was purchasing Adam’s Golf a couple years before the company was purchased be Adidas. He made a massive profit on the deal and he certainly didn’t chalk it up to knowing about golf. He didn’t go to his local course and talk to his country club friends about the fact that everyone was using Adam’s Golf equipment (because they weren’t, it was a relatively small company when compared to giants such as Adidas’ TaylorMade and Calloway). JT made the deal because he understood the business behind the product. At the end of the day, it really doesn’t matter how good the Adam’s Golf product is – it only matters if they sold enough product to be extremely profitable and an enticing takeover target.

Numbers Matter More Than What You Think You Know

The phrase “buy what you know” is completely taken out of context by most “financial gurus”. What Lynch and Buffett know it great detail (which allows them to understand) is how to evaluate company fundamentals. Now I certainly don’t claim to be an Oracle, or even a Money Mamba, but I have picked up enough to know that just because a company is popular, or has been great in the past, doesn’t mean it is a good investment. This completely ignores the reality of looking at a stock price (basically the price of the company) as compared to how much money the company might reasonably make in the future. This is where things like price-to-earnings (P/E) ratios, balance sheets, cash flow projections, moats, sector outlooks, and management turnover come into play. If you aren’t completely comfortable with these metrics and what they mean, they you don’t really know what you’re buying.

“I Know One Thing – That I Know Nothing” – Socrates

This sort of overestimation of our own abilities to “pick winners” based on the sensory input of the environment around us on a daily basis is likely one of the biggest reasons why people who pick their own stocks do so much worse than index investors. A recent study by Morningstar stated that the average stock investor trailed the average returns generated by the stock market from 24% from 2001-2011. This study is not an anomaly. A Dalbar study from 1990-2010 showed that while the S&P 500 had an average return of 9.1% for the twenty year period, the average American stock investor achieved a 3.8% return. I’m sure lots of these investors figured they “knew” what they purchasing as well.

Unless you’re willing to put in the time to truly understand the investments you’re making, you’re almost assuredly better off staying out of them altogether. Statistics would argue most investors don’t even understand how much they don’t know – and that degree of folly can be pretty destructive when mixed the overconfidence born of reading to many space-filler articles from investment publications whose livelihood depends upon active trading strategies amongst retail investors. Instead you'd be way better off reading up on simple solutions like Canada's robo advisors – who will take your money and invest it in a basket of index funds so that you can use your brain space for more productive pursuits!

12 Comments

Nice post Teacher Man, this kind of thinking aligns very well with the strategy I have put in place for myself – I use statistics and mathematical analysis to provide me with some substance to base my investment decisions on rather than just gut feel. It may not be a perfect system, but it helps me keep any emotional responses outside of my decision making.

At least you have a system Michael! How have you done versus your index over the last few years?

Philon August 19, 2013 at 10:01 am

Peter may be marketed as a “Buy what you Know” kind of guy but if you read any of his stuff you will find that statement is taken out of context by the media from his books as an easy to market tag line. Peter has always stressed the importance of exploiting an edge, so yes start with investing in what you know by taking advantage of what you already know and see each day and then evaluate and follow through with appropriate amount of DD (due diligence). Unfortunately many hear Buffet makes a move, and then the heard follows. Yes he and Peter have proven over time that they can pick’em, but in their careers they have made some pretty big mistakes too for being portrayed as investing Gods, which for whatever reason the media rarely likes to report – Successful investing/trading boils down to 2 things, research and patience, nothing else, well other than maybe a pinch of pixie dust – Cheers.

Philon August 19, 2013 at 10:11 am

I will add before asked – I invest solely in the Cdn market, and have averaged 8% over the past 15 years. I invested in mutual funds as a start (PH&N, Bissett) (60% of current investment holdings), then after some reading made some moves in materials and commodities with more aggressive funds (Sprott) (Sold back in late 2007 for a tidy profit to purchase real-estate), and now control a good portion in my TFSA and non-registered accounts (40% of current investment holdings) with growth companies and reasonable divvy stocks (AYA-T, CMI-T, MDA-T & MMT-T as examples) – Research and patience…

I absolutely agree Phil. The media definitely distorts the investing ideas of those two titans. And obviously they’ve made a few mistakes, anyone with their number of trades has right? Patience and research – couldn’t agree more. Of course, my research for the moment tells me I’m not educated enough to beat my indexes, so there you go! I like to think I’ve got the patience one down – but it might be one of the only areas of my life were I would characterize myself at “patient”.

8% over 15 years is pretty decent. Considering how much you’ve learned I’ll bet you’ll do better (at least relative to the general stock market) over the next 15! Any reason why you choose to stay within the Canadian market exclusively?

Also, if you’re a real estate guy would you mind dropping by my fourplex article I wrote last week and sharing your thoughts? Thanks!

Philon August 19, 2013 at 11:57 am

I’m not a real-estate guy… I bought a second property – chalet, next to a ski hill, that I have debated about renting out, but now having owned for 5 years finally decided to just use it for my family and invite/offer it for close friends as a refuge from the daily grind – Call it my personal type of philanthropy. Reason we do not rent, the hassles with being near a resort and the type of renters…

Philon August 19, 2013 at 12:04 pm

For the record, I am an Engineer, with much experience in quality/reliability field, so research and analyzing data comes natural to me. There are always good companies out there in all up and down markets. It is the research that will identify them and the patience part is the time it takes to prove the research was worth while. – Cheers.

Philon August 19, 2013 at 12:08 pm

Exclusive to Cdn market because that is what I know. Way more corruption in the world than most know. I am familiar with Canadian corporate laws, and as such, only invest here… Hummmm … I invest only in what I know and understand, and it has worked for me over the past 15 years…

Good post, but I agree with other comments and yours, the Lynch quote is often taking out of context.

Due diligence is always part of the equation, and that includes indexed products.

That said, some companies to own, if you are going to own them, are “no-brainers”. Maybe I will be proven wrong, but Canadian banks and U.S. companies like Coca-Cola and Walmart should be dividend studs that also provide capital appreciation for decades to come.

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